The Pros And Cons Of Investing In Microsoft Stock

blinkix
2022-04-15

Summary

  • Microsoft's valuations appear to be reasonable following a comparison of the stock's key metrics with its FAANGM peers.
  • MSFT's pros or investment merits like revenue predictability and Azure's growth potential do stand out; but I am wary of cons or risks like competitive threats and weaker-than-expected profitability.

$Microsoft(MSFT)$ forward P/E valuation is right in the middle of the pack when compared to its FAANGM peers. This appears to be aligned with expectations that MSFT's forward two fiscal years revenue growth is ranked fourth in this group of six companies.

On the flip side, MSFT's forward Enterprise Value-to-Revenue and EV/EBITDA multiples are the most expensive and the second most expensive in the peer group, respectively. But Microsoft's expected ROEs for the next two years are the second highest among its FAANGM peers, which seems to provide support for the stock's relatively higher Enterprise Value-to-Revenue and EV/EBITDA valuations.

In summary, the peer comparison above suggests that Microsoft's valuations are relatively fair, and there does not seem to be a mismatch between its valuation multiples and its key forward-looking financial metrics (revenue growth and ROE).

Pros Of Buying Microsoft Stock

I think that the pros of buying Microsoft stock include its high degree of revenue predictability, the long growth runway for Azure, and its intelligent use of share buybacks.

Revenue Predictability

Microsoft boasts a high degree of revenue visibility and predictability, and there are a number of key indicators supporting this assertion.

Firstly, MSFT revealed at its most recentQ2 FY 2022 earnings callon January 25, 2022 that its "commercial remaining performance obligation increased 31% and 32% in constant currency to $147 billion" and guided that "roughly 45% will be recognized in revenue in the next 12 months." It also disclosed that its "annuity mix (for Microsoft Cloud) increased one point year-over-year to 94%." In other words, Microsoft boasts significant contractual recurring revenue streams which is a key positive for the stock.

In its Q2 FY 2022 10-Q filing, Microsoft noted that commercial remaining performance obligation includes "unearned revenue and amounts that will be invoiced and recognized as revenue in future periods." It also highlighted in its recent 10-Q filing that Microsoft Cloud refers to "Azure and other cloud services, Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties."

Secondly, Microsoft has exceeded market expectations in relation to its revenue growth for 15 of the past 16 quarters as per the chart below. For the single quarter (quarter ended December 2018) that MSFT suffered from a revenue miss, the company's actual revenue only came in -0.1% below the sell-side's consensus top line forecast.

Microsoft's Quarterly Revenue Surprise

Thirdly, the market values Microsoft at a consensus forward next twelve months' Enterprise Value-to-Revenue multiple of 10.2 times which is the highest among the FAANGM companies as I highlighted in the prior section. Although MSFT's forward revenue growth rates are not the fastest in the FAANGM peer group, it is reasonable to assume that the market is willing to assign a relatively high Enterprise Value-to-Revenue valuation multiple to MSFT because of its revenue predictability and visibility.

Long Growth Runway For Azure

Azure is referred to as Microsoft's public cloud computing platform. On its website, MSFT describes Azure as "a platform" comprising over "200 products and cloud services" to assist companies to "build, run, and manage applications across multiple clouds, on-premises, and at the edge." In Q2 FY 2022, Microsoft's Intelligent Cloud business was the fastest growing of the company's three key segments boasting a YoY constant-currency growth of+26%. Within the Intelligent Cloud segment, Azure was the star with its revenue up +46% YoY in the recent quarter.

Looking forward, Azure has a long growth runway ahead considering the industry's growth prospects and its market share gains.Gartner, Inc.(IT) forecasts that the cloud will represent51%of information technology spend for the "application software, infrastructure software, business process services and system infrastructure markets" by 2025 as compared to a 41% contribution in 2022.Gartneralso predicts that the proportion of "new workloads deployed in a cloud-native environment" will rise from 30% in 2021 to95%in 2025.

Microsoft's Azure is in a good position to benefit from the growth of the cloud market given that it has been a share gainer in the past few years.

Share Repurchases

Microsoft announced its latest$60 billion sharebuyback program in September last year. As a comparison, MSFT had a relatively lower share repurchase authorization of $40 billion for its prior share repurchase programs in 2013, 2016, and 2019, respectively.

A review of Microsoft's past share buybacks suggests that the company's most significant share repurchases in recent years occurred in the third quarter of fiscal 2015 (first quarter of calendar year 2015) where it bought back approximately 1.4% of its outstanding shares in that quarter. MSFT's shares declined by -18% from$49.46as of November 17, 2014 to as low as $40.66 as of March 31, 2015, and this could have promoted the company to buy back its shares more aggressively. Microsoft's stock price subsequently rebounded to $44.15 as of June 30, 2015, and eventually closed the year at a much higher price of $55.48 as of December 31, 2015.

In other words, it is clear that Microsoft views share repurchases as both a means of returning excess capital to its shareholders, and an opportunity to boost shareholder value by engaging in opportunistic buybacks when its share price is depressed.

With its shares having corrected by -16% from its all-time high of $349.67 recorded during intra-day trading on November 22, 2021 to $294.39 as of March 16, 2022, it is possible that Microsoft accelerates its pace of share buybacks in subsequent quarters which will provide support for its stock price. As a reference, MSFT bought a modest 0.3% of its outstanding shares in the recent second quarter of fiscal 2022.

I highlight the potential risks and negative factors for MSFT in the next section.

Cons Of Buying Microsoft Stock

Competition With The Other Internet Giants

Microsoft competes with the other internet giants in many business areas, and if there is any indicator that MSFT is losing ground with its FAANGM peers, investors might feel compelled to switch to the other FAANGM stocks.

One key area to watch is that Microsoft has a limited direct presence in the mobile market unlike its key FAANGM peers like Alphabet and Apple which dominate the mobile application ecosystem. As an example, Apple's recentiOS privacy changeshave hurt the performance of another FAANGM name, Meta Platforms, and this points to the vulnerability of certain other companies with respect to their reliance on Apple's mobile operating system.

Another key issue to monitor is the market share of Amazon AWS in the cloud market. Although Azure has been gaining market share at the expense of other smaller rivals in recent years, AWS' market share has remained relatively stable. This implies that AWS' dominance of the cloud market puts some form of a cap or ceiling on Azure's future revenue growth and eventual scale.

More importantly, the lines between the FAANGM companies are blurring, and more of them are entering similar business areas and trying to capitalize on the same growth trends such as the Metaverse. Moving ahead, the internet giants could be directly competing with each other even more often than one would expect.

Future Profitability

Market consensus expects Microsoft's EBIT margin to increase from 41.6% in fiscal 2021 to 42.4% in FY 2022, before further expanding to 42.8% and 43.9% for FY 2023 and FY 2024, respectively as perS&P Capital IQdata. This is largely based on assumptions of growing scale for some of its key fast-growing businesses like Azure which brings about positive operating leverage effects.

As I mentioned earlier in this article, Microsoft's expected ROEs are the second highest among the FAANGM companies, and this allows the stock to trade at premium EV/EBITDA and Enterprise Value-to-Revenue multiples. Lower-than-expected profit margins (and consequently ROE) could possibly lead to a valuation de-rating for Microsoft's shares going forward.

Potential Pivot To Consumer Markets

The good financial and stock price performance of Microsoft in recent years is largely attributable to the company's success in enterprise markets. In contrast, most of MSFT's past forays into the consumer markets such as Groove Music and the Windows Phone have been disappointments, though it has done reasonably well with Xbox and Surface.

Conclusion

The bottom line is that Microsoft is a Hold after assessing the investment merits and risk factors for the stock and comparing its valuation against FAANGM peers and history.

Disclaimer: Investing carries risk. This is not financial advice. The above content should not be regarded as an offer, recommendation, or solicitation on acquiring or disposing of any financial products, any associated discussions, comments, or posts by author or other users should not be considered as such either. It is solely for general information purpose only, which does not consider your own investment objectives, financial situations or needs. TTM assumes no responsibility or warranty for the accuracy and completeness of the information, investors should do their own research and may seek professional advice before investing.

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